Many people are taking advantage of the tax benefits that come along with Roth accounts. No matter what your income or tax status is, you can take advantage as well.
What is a Roth Conversion?
A Roth conversion is when you convert a pre-tax account (Traditional IRA, 401k, 403B) to a Roth IRA. By doing this you pay the taxes now on any money converted over, and get the benefit of never having to pay taxes on that money or its growth ever again.
Advantages of a Roth IRA
With a Roth IRA you have many tax advantages over a Traditional IRA. The most obvious one is that any money you take out after age 59 1/2 and after having the account open for at least 5 years is 100% tax free. As a part of this benefit is that there are no required minimum distributions at age 70 1/2, and your Roth money can go tax free to future generations at your passing. Another advantage is that you can always take the total amount contributed to a Roth IRA out without any tax penalty, even if you are not 59 1/2. It is just the growth on the account that would cause a penalty if taken out early.
Do I qualify for a Roth Conversion?
There are no income restrictions or limits for who can convert to a Roth IRA. There are income limits for contributions to a Roth IRA, but not conversions. Because of this anyone who wants to can take advantage of this possible huge tax saving trick.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is for savers that don’t qualify to contribute to a Roth IRA because their income is too high. There is a way for them to contribute to Roth IRA by first contributing to a Traditional IRA with after tax money and then immediately converting the money in the Traditional IRA to a Roth IRA. Because there are no income limits on after tax Traditional IRA contributions this is legal, and can be very beneficial in terms of tax savings.
How much will it save me?
Just to show you the power of a Roth account vs a Pre-tax account, I will give you an example. Elicia is 30 years old and plans to contribute $5500 a year into a Roth IRA until retirement at age 65. Ryder is also 30 and plans to do the same but into a Traditional IRA. In this example I will assume they both get exactly the same return(8% before retirement, 6% after), are in the same average tax brackets each year(30% before retirement, 15% after), and take the money out over a 25 year span in retirement. During the working years Ryder would have saved $57,750 on taxes compared to Elicia’s $0 saved. But as they took the money out in retirement Ryder will pay $250,667 to Uncle Sam while Elicia will pay $0. In this example, a Roth IRA saved Elicia almost $200,000 in tax payments to the government.
Is a Roth Conversion for Everyone?
A Roth Conversion is not right for everyone. There are a lot of things to consider depending on your age, tax bracket, and current investments. A Roth Conversion may be very beneficial to you, especially in the long run, but you need the help and advise of a knowledgeable investment coach to decide if it is best in your situation.
By Jimmy Hancock